Land development loans are usually a secured form of borrowing for the purpose of preparing land for future construction. They are typically used to finance the grading of a property and the installation of streets and utilities. In some cases, the loan may also finance the purchase of the land. Land development loans may be repaid from the sale of improved lots to other builders, or they may simply be rolled into a construction loan to the same borrower.
To effectively administer a land development loan, a Bank should require the borrower to submit a feasibility plan that describes each step of the development. The feasibility or development plan should include all projected costs of the development, including costs for obtaining building and zoning permits, environmental impact statements, and other associated costs, such as any off-site improvements required by the local building authority.
A Bank should structure the repayment program to follow the project’s development or sales program. A land development loan should have a sufficient spread between the amount of the loan and the estimated market value of the project to provide a margin for unforeseen expenses. If the loan involves the periodic development and sale of portions of the property under lien, each separately identifiable section of the project should be independently appraised and any collateral should be released in a manner that maintains a reasonable margin.
Banks commonly finance land development work for larger, residential tract projects in several sections or phases. This allows the Bank to control the risk and ensure that an oversupply of developed lots does not occur. Release prices for the lots in the early sections of the project are set at a level that is sufficient to ensure a comfortable margin on the payout of the land development loan for the entire project. Banks commonly set lot release prices that are sufficient (typically in the range of 125 percent of the lot’s loan value) to ensure that the break-even or repayment point for the entire loan is reached with the sale of about two-thirds of the total available lots in the project, or when the project has achieved no more than 80 percent of the expected net sales proceeds (usually referred to as the repayment rate). See Chapter 12 for a more detailed discussion of Residential Development Lending.
When a land development loan to borrowers who are investors or speculators is unsecured, it is critical for a Bank to analyze the borrower’s financial statements to determine the source of repayment. Moreover, a Bank should be wary of overly optimistic sales projections and avoid making loans to highly leveraged borrowers or borrowers with nonliquid net worths.